Why consider prefunding

pensions?

Edward Whitehouse

OECD

World Bank core course

Washington DC, November 2009

Agenda

Different financing mechanisms:funding and pay-as-you-go

Advantages and disadvantages

Design of funded schemes

Moving from pay-as-you-go to funding

Initial conditions needed for funding

Unfunded/pay-as-you-go schemes

Use contributions from current workers to pay benefits to current retirees

This gives current workers “promises” in return for contributions

Promises must be met by future generations

Promises have different legal weights countries:

from constitutional right to changeable promise

Prefunding

Contributions from current workers are used to accumulate assets

These assets are used to pay benefits in the future

Schemes can be partially funded

Benefits for current workers will be paid for by a mix of accumulated assets and taxes/contributions paid by future workers

Potential advantages of funding

Better able to deal with aging of the population

Better rates of return on pension contributions

Limits fiscal liabilities

Removes some labour-market distortions

Helps develop capital markets

Possibly increases savings and investment

Reduces politicisation of the pension system

Demographic change: ageing

0

2.5

5

7.5

10

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

OECD-30

Oldest

OECD

country

Youngest

OECD

country

Number of people of working age per person of pension age, 1950-2050

Ageing and unfunded schemes

Ageing occurring because:

fewer babies (reversable?)

longer lives (permanent?)

Impact on pension systems is to increase number of retirees relative to contributors

Governments must

increase contributions, raise retirement ages or cut benefits to maintain fiscal sustainability

It becomes increasingly difficult to protect workers in their old age

An example: the United States

Real rate of return on contributions (%)

Ageing and funded schemes

Likely impact of ageing on capital markets uncertain, but probably small

Different cohorts may have different rates of return on their contributions

But not systematically related to ageing

Also, option of foreign investment if returns are higher elsewhere

Rates of return: PAYG and funded

Sustainable rate of return on PAYG = growth of labour force + increase in average earnings

can turn negative when labour force starts to shrink

Rate of return on funded = capital-market return

historically, even with financial crises, this has been larger than wage growth

Fiscal liabilities

PAYG scheme: government responsible for covering deficit

No fiscal liabilities for new entrants in a pure funded scheme

Individuals‟ benefits are based on amount they saved

Distorted labour markets

PAYG schemes often:

encourage early retirement

are not portable between different jobs

are based on final salary, encouraging under-reporting of earnings in early years

Funded schemes:

generally pay higher benefits to people who work longer

are easily portable between different jobs

are based on contributions in each and every year

Capital-market development

PAYG schemes: can hinder capital-market development if substitute for private savings for retirement

Funded schemes tend to lead to greater variety of financial-market instruments offered

Savings are usually intermediated through financial markets

Some suggestion that this has a positive impact on savings and economic growth

Politicisation of pensions

Politicisation can be a problem:

uncertainty in retirement benefits of current pensioners and workers

potentially divisive political battles between those who receive pensions and those who pay for them

Under PAYG, easy for governments to make promises of future benefits

they will be out of office before the costs have to be met

With funded schemes, higher benefits only possible with higher contributions now

Investment risk

Funded schemes subject to investment risk

Important to distinguish time periods

long-term risks are not too large because rates of return relatively stable

short-term risks can be large if the markets fall when you want to retire

Measures to mitigate risks of financial crises

Important to remember risks with PAYG

political risk: a new government changes its mind

fiscal risk: there isn‟t enough money to pay for pensions (arrears)

Old-age poverty

Funded schemes have risks of poverty for:

people with incomplete work histories (unemployment, disability, childcare etc.)

people with low levels of earnings

But PAYG schemes that tie benefits closely to contributions have the same problem

Also, political and fiscal risks

Pension systems with funding

There is generally also a PAYG-financed benefit in systems with funded schemes

Ranges from:

minimum pension/means-tested scheme only (Australia, Mexico, Kazakstan, El Salvador, Hong Kong)

basic pension only (Kosovo, Netherlands, new system in UK)

earnings-related, public schemes (Uruguay, Costa Rica, Slovak Republic, Poland, Hungary, Latvia, Lithuania, Estonia, Croatia, Bulgaria, Macedonia, Switzerland, Sweden)

Providing funded schemes 1

Many possible structures

single public agency (Russia)

single pension fund, but private (Bolivia)

a few private pension funds (Uruguay)

many private pension funds (Chile, Poland, Hungary)

public and private pension funds (Mexico)

Investment choice

single portfolio per pension fund

multiple portfolios per pension fund

restrictions on who can own what type of portfolio

Paying out funded pensions

Annuity

pension balance transferred to insurance company which provides regular payments

indexation?

survivors benefits?

Programmed withdrawal

balance divided by life expectancy determines pension in any given year

remainder continues to earn interest

Lump sum

Combination of or choice among the above

Collection and record-keeping

Centralised:

social-insurance agency

tax authorities

separate institution (public or private)

Decentralised

individual funds do the work

Moving from PAYG to funding:

transition costs

If all or part of contributions of current workers are diverted to funded accounts, how can current pensions be paid?

Possibility of transition „double burden‟

one generation pays for its own and its parents‟ pensions

Also, current workers also have rights accrued in the public, PAYG scheme

e.g. a 40-year old may have 20 years of contributions in the PAYG scheme and needs compensating

Accrued rights

Existing pensioners: benefits continue to be paid as before

Existing contributors:

maintain a pro-rated benefit from the PAYG scheme

„recognition bonds‟: value reflects accrued benefits, bond can be accessed at retirement

How are accrued rights valued?

e.g., indexation, retirement age, accrual rates, minimum pensions

Transition costs and design issues

Who is allowed to switch to the funded scheme?

option or mandatory?

age cut-offs?

Gradual increase in contribution rates to funded scheme over time

Room to increase overall contribution rates?

„add-on‟ versus „carve-out‟ funded scheme

Conditions for a funded scheme

Is the macroeconomy stable enough to offer reasonably safe financial instruments?

Are sufficient financial instruments available?

option of foreign investment

but exchange-rate issues and political economy

Financial market regulation and supervision must be strong

contributions to a funded pension are mandatory, unlike other savings instruments

they are also longer-term savings

Administrative capacity: record-keeping, valuation